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At Chesapeake Energy it's time to show, not tell

Chesapeake Energy Corp (CHK-N) is under the gun to show evidence that it is changing its free-spending ways when it reports third-quarter earnings on Thursday..

The company's largest investors, Carl Icahn and Mason Hawkins, were so unhappy with the company's bloated balance sheet that they seized control of the board in June. With more than four months of work under the new board's belt, analysts and investors are looking for signs that change is under way at the second-largest producer of natural gas in the United States after Exxon.

"I think everybody is going to be looking very closely at this first full quarter they've had since the major changes," said Jake Dollarhide, chief executive of Longbow Asset Management, which holds Chesapeake bonds and stock. "It will be very interesting to see how these numbers compare to a year ago."

Chesapeake has dropped a few hints that have heightened expectations about the report due on November 1.

"Management and the board of directors are currently reviewing operations for 2013 and beyond," the company wrote in its second-quarter earnings release, and said more details would come in the third-quarter earnings report.

And when Chesapeake renegotiated loan covenants on its $4 billion credit facility earlier this month, the company arranged a "sliding scale" where the allowable ratio of debt to earnings before interest, taxes, depreciation and amortization (EBITDA) slowly ratchets down to 4.2X by September 2013 from 6X in September of this year.

EBITDA is a measure of a company's profitability.

The declining debt to EBITDA ratio is seen by some as an indicator that the company intends to scale back its spending and earnings.

Tim Revzan, an analyst with Sterne Agee, is looking for what he describes as meaningful change to the company's budget next year, including a plan that more closely aligns the company's spending with its cash flow.

"The important number is going to be 2013 spending," Rezvan said. "The company has signaled pretty strongly it doesn't want to rely on asset sales," Rezvan said.

In the second quarter, Chesapeake said it expected capital expenditures to range from $12.8 billion US to $13.6 billion this year and then sink to $7 billion to $7.75 billion next year.

If next year's budget does shrink, Mark Hanson, analyst with Morningstar in Chicago said he expects spending on new acreage and the company's oilfield services unit to see the largest cuts.

BUY, THEN SELL

Chesapeake spent more than $31.2 billion in the last 15 years to acquire oil and gas properties, mostly in shale formations around the United States, according to Morningstar. That amount pushed up the company's long-term debt to about $13 billion, close to its market capitalization of about $14 billion.

A prolonged decline in natural gas prices left the company with a 2012 cash flow shortfall of up to $10 billion, a situation that forced Chesapeake to rely on asset sales to plug the funding gap.

So far, the company has sold or agreed to sell about $12 billion of acreage, pipelines and processing plants, sales that have eased most liquidity worries for this year.

Southeastern Management's Hawkins, who owns nearly 14 percent of Chesapeake, did not respond for a request for comment. But in his letter to shareholders for the second quarter, he said he advocated "de-risking the balance sheet, managing costs and reducing discretionary spending."

Still, forecasts for lower spending next year would only be a first step. A Reuters investigation showed potential conflicts of interest by Chief Executive Aubrey McClendon, among other issues.

Chesapeake's "management needs to prove over a sustained period that it would abide by a more conservative and transparent approach to regain trust of investors," analysts at Deutsche Bank said in an October 8 note to clients.

Chesapeake declined to comment.

Other items that may be included in the third-quarter earnings report include: a write-down of the value of some of the company's natural gas assets and an update on Chesapeake's efforts to find a joint venture partner or buyer for some of its 2 million acres in the Mississippi Lime formation in northern Oklahoma and southern Kansas, analysts said.